Asset Prime

Wednesday, March 20, 2013

A commodity must be fungible. The value of a bushel, barrel, or ounce of a given commodity comes not from its uniqueness, but from the fact that it is functionally identical to every other bushel, barrel, or ounce of the same commodity. Insuring fungibility is exactly the reason commodities contracts have explicit specifications. In addition, many different types of commodity are highly interrelated and as such, so is their price. Consider for example the relationship between oats and corn, both used frequently as livestock feed. If corn gets too expensive ranchers might begin feeding their livestock more oats. As more people forgo corn in favor oats, corn prices will inevitably fall as oats' go up, which will ultimately cause more folks to switch back to the (now cheaper) corn, and the cycle repeats. Obviously, the more related two commodities are, the more their prices are correlated. Nowhere is this fact more salient than in the various types of crude oil globally traded. And, unlike corn and oats, which have several non-overlapping uses, there's really only one thing to do with any type of crude: refine, then burn it.

The two major crude oil contracts traded in global markets are West Texas Intermediate, which is the American standard (what media outlets have traditionally meant when they talk about the "price of oil") and Brent Crude, which is the British standard. The former is traded on the NYMEX, the latter the ICE, and you can read their contract specifications here and here, respectively. Both are high-quality, refineable oils (referred to as "light, sweet crude") with the primary difference being that WTI contains less sulfur and is somewhat less dense than its British counterpart. Now, I'm not an oil man, so someone who's worked in petroleum engineering and/or regularly wears a huge cowboy hat could do a better job explaining the specifics, but my understanding is that less sulfur and a lower density means WTI is easier to refine, making it technically the superior oil. In theory, this should make for an obvious reltionaship between the contracts: higher quality, higher price. Not so.

For years the prices of the two contracts reflected the quality difference, as historically American Crude Oil has traded a few dollars above the price of Brent Crude. However, about 2008 (largely I'm sure as a result of the financial crisis) the two oils began occasionally trading places, with Brent breaking away from WTI in late 2010/early 2011 and never looking back. Observe this chart:

There are a few key things to notice. First, as mentioned above, observe Brent's breakaway from WTI beginning right around 2011, a pattern that seems to have more or less stabilized today, with Brent now consistently trading $10 - $20 higher than US crude. Think about that for a minute: two products with identical uses, the only difference their respective qualities, and the inferior product is valued by the market ~15% above the superior. That's like paying $45,000 for a Volkswagen Jetta when an A4 costs forty grand, or dropping $12 on a pound of Folgers when Shade-Grown Artisanal Hipster Roast™ only costs $9.

Brent most likely overtook WTI for three major reasons: the glut of domestic crude created as American supply has gone up from new oil discoveries; the decreased demand for oil domestically due to economic stagnation; and the ongoing, wrongheaded legal restrictions preventing the exportation of US crude. That a literally inferior product is more expensive in open global trading is a testament to just how screwed up the US oil market has become, and further proof, as I've written before, that it's time to lift restrictions on US oil exports.

That said, the other thing to notice about the chart above is how synched up the movements of the two crudes has been over the last five years. Even when they're at their furthest apart, a movement by one crude usually coincides with an almost identical movement by the other. This, of course, makes sense, as these two commodities are almost the exact same thing. In this way, any savvy oil investor should be knowledgeable about both types of crude, as the market climate may at any given moment favor one contract over the other, or in absence of a preference between the two, the other variety might be used as a powerful hedge (e.g. going long three contracts of WTI, and short one of Brent).

But in a classic case of the exception proving the rule (yes yes, I know that's not what that actually means), this lock-step relationship is by no means a permanent state of affairs. Here's a scatter plot of WTI prices compared to Brent Crude from 2008 through 2010:

The r_squared (extent to which variability in one is explained by variability of the other) is .9918 - almost a perfect correlation. Now, here's a scatter plot of WTI prices compared to Brent Crude from 2011 exclusively:

What the hell? These are still the same two types of crude oil, right? For reasons I cannot fully explain, though which I'm positive have more to do with geopolitics than actual supply and demand, the correlation between the crudes falls apart in 2011. We're looking at an R_squared of .5253, which, obviously, is a remarkably less meaningful correlation than the 99% we observed in years prior. That the correlation seems to evaporate when the two contracts switch places might indicate the relationship not only flipped, but moved out of synch entirely. So let's take a look at how the two have behaved from the start of 2012 until now:

Not bad. The R_squared is .7840, not as strong a correlation as pre-2011, but definitely moving back towards the lock-step we became used to seeing.

The takeaway point here is that highly related commodities tend to have high degrees of correlation, except when they don't. That first tidbit (related commodities are correlated) may not seem like news, but it's a fact commodities investors all too often overlook when thinking about risk. As mentioned above, using related (or near identical) commodities as a hedge is a great way to protect oneself in what are inherently risky markets, and taking a complimentary position in the other type of crude is a great way for oil investors to mitigate risk. That said, the more a market is caught up in politics (and it'd be hard to find a more politically charged market than US crude) the more likely it is to be reactive to exterior, non-market forces.

Though it may not seem like it, this difference between the price drivers for the two crude contracts is actually good news for oil investors; that the prices fall in and out of correlation allows investors to trade on different types of information. For example, an investor who's very attune to the geopolitics of oil would be well suited to make her play in the US crude market, where policy can affect the price as much or more than the underlying market factors. Conversely, an investor who's largely ignorant of US oil policy but has a very good understanding of global oil market fundamentals might want to stick to Brent Crude (though of course being aware that major shifts in US oil policy ought to effect all oil everywhere). Both investors then, as described above, could in theory use the other type of oil as a hedge.

Regardless, any oil investor needs be acutely aware that the powers governing oil prices can and frequently do have nothing to do with the underlying market forces, and one's strategy in these markets needs to take this information into account.

Tuesday, November 20, 2012

The big news in energy last week was that the International Energy Agency projected the United States will overtake Saudi Arabia as the world's leading oil producer by 2020. If accurate, the significance of this information is hard to overstate, and its ramifications for the economic, military, and political future of the world are myriad and complex. In theory, at its most basic, this means cheap oil and an end to foreign energy dependence, but, as you'd expect from so multiplex a commodity, it's not that straightforward; indeed, the forthcoming US oil production boom is nothing short of a geo-eco-political imbroglio.

From a market point of view, the first consequence one would expect would be for crude to become a demand-driven market; if we have all the oil we need from sea to shining sea, supply would play less of a factor on the price of a barrel then would the demand to burn it up. Unfortunately, it's not that easy. For the price of a good to accurately reflect the pressures of supply and demand, the market has to be open to all participants - a market can't operate (or at least maintain liquidity) without scores of individuals buying and selling. However, it turns out the oil market is much more constraint-laden than other global commodity markets (rice, lumber, coffee, etc). There are a few reasons for this. The first, which I didn't know until after this story broke (and which became the impetus for my writing this piece), is that the United States generally prohibits exports of crude oil. That's right, America, bastion of free markets and free men, generally disallows the exportation of one of the planet's most basic economic inputs. (This, I have to assume, is one of the many reasons why Brent Crude, a somewhat inferior British grade of oil has for the last couple years been trading at a price significantly higher than its American counterpart, but that's a topic for another day.) While it isn't technically illegal to ship crude offshore, regulators certainly don't make it easy; as far as I understand (and someone please correct me if I'm wrong), any exporter of American crude is required to get dispensation from the Department of Commerce, and even then the exporter is highly restricted in his or her trade.

The other major piece of the puzzle is the US military presence in the Persian Gulf. NPR had a good story last week explaining the situation. The gist is, for decades now, the US has kept several aircraft carriers permanently stationed in the Persian Gulf specifically for the purpose of keeping oil shipping lanes open, protected, and safe. Not coincidentally, the US and her allies get a ton of their oil from countries whose continued exports rely on open, protected, safe shipping lanes. Heretofore it's been a win-win, but if the US no longer needs foreign oil, then what interest would we have in protecting the shipping lanes of other nations, especially when every other oil consumer (China, India, Brasil, etc.) directly benefits from the US military presence in the Persian Gulf. (Anyone planning to run for President in the next four elections: I've just given you the sort of military policy that would likely resonate with about half the population.)

Okay, you might think, so the Middle East would become more unstable (if that's possible) without a permanent US military presence, what has that got to do with the price of oil if we're extracting all we need domestically? Consider a world in 2025 where US oil exports remain strictly regulated, nations in the Persian Gulf must allocate tremendous expense to secure shipping lanes, and the Peoples' Republic of China has a fully modern economy with a healthy appetite for petroleum products. You've now created two entirely distinct international markets for oil, nurtured a hidden economy built on piracy and black markets, and functionally turned the United States into a global oil cartel. In this fertile breeding ground for militarism, the newly modern navies of the world would swell to protect oil access, conflicts in crude producing nations would flare up like oil fires, and all the while the US (whose oil consumption has incidentally been falling and will likely continue to fall) sits on an ocean of oil, unwilling to share and unable to profit from its export.

On the other hand, the US could lift entirely its restrictions on crude exports (treating crude the same way we treat almost every other commodity on the planet). In so doing, American crude would compete with Middle Eastern and other geographic varieties of oil; nations would have less incentive toward militarization as crude is more readily available; the global economy would grow as more countries are able to modernize on the back of readily accessible, transparently priced energy; and, most important to any commodities investor, the price of oil would reflect, simply, the price of oil.

I realize that in the course of this piece I have not addressed the very real need to switch to renewables. This is obviously tremendously important for the future of our planet, our environment, and our continued existence as a species, but the US won't hasten a fully green economy by extorting other countries and forcing them into war-mongering. As America moves forward, she should not cling to cold-war ideas about resource protection and paranoia; this is the land of the free, after all. Our markets should be likewise.

Briefly, the vast majority of commodities markets follow a normal futures curve, wherein the prices for contracts of a commodity further out are more expensive than the contracts closer to expiration. That is, in February of a given year, the price for March widgets would be cheaper than the price for July widgets. (People usually call this situation "contango"; and while that's not technically correct, it's not worth getting into the semantic distinction in this article, other than to acknowledge that people are going to be using that word to describe a normal futures curve.) Most commodities ETFs work by holding the front month contract of a given commodity, then selling that contract shortly before expiration and replacing it with the next month in the futures chain. If, indeed, the market is in a normal futures curve, the next month contract in the chain will be more expensive than the contract approaching expiration. Selling low and buying high does not typically a profit make. Hence, even when the price of a commodity is increasing over time, much of that value may be lost to the monthly roll-yield penalty.

This is important, because the entire purpose of a commodities ETF is to track the price of a commodity, thereby providing investors exposure to those markets. Significantly, most commodities ETFs do not do this. At all. Commodities ETFs do not do the one thing they were created to do. Commodities ETFs are terrible.

Interestingly, many of the banks that issue these ETFs (or ETNs, as the case may be) have gotten more upfront about the issue. The iPath commodities ETN page, for instance, discusses the roll yield before even listing the funds one can invest in, and their "iPath Commodity ETNs" pdf sheet includes a handy graphic (displayed at right) explaining the nature of the problem. (Incorrectly, of course, calling a normal futures curve "contango" but again, that discussion belongs elsewhere.) I have to admit that I'm impressed at the level of disclosure by iPath here; I don't know the extent to which a bank is even required to do this. However, while the facts given are certainly correct, the prospectus fails to mention that the majority of the time, the market is in a normal futures curve ("contango") rather than an inverted curve when a fund would potentially make money ("backwardation") from the roll yield. That is, they fail to mention that most of the time, the roll yield is a bad thing.

Some banks, of course, have gotten wise to this problem and have implemented funds that attempt to avoid the pitfalls of the standard roll yield. The United States 12 Month Oil Fund (USL), for instance, (cousin to the much more popular USO fund) holds all twelve futures contracts for the upcoming year (one for each month) rather than just the front month contract. iPath (mentioned above) offers a series of Commodities ETNs that use a proprietary algorithm to select which contract a fund should hold. The basics of the strategy are overviewed in their document "Basics of iPath Pure Beta Commodity ETNs" on the iPath website. I examined USL in the aforementioned HardAssetInvestor article and found a much better statistical correlation between that fund and the price of oil compared to similar funds. I haven't had a chance to dig into the iPath Pure Beta ETNs (having just learned about them), but I'm very curious to know how good they actually are at mitigating the roll yield. You can be sure I'll report back here with any and all findings.

Even if it's coming three years too late, I'm glad to see folks are finally waking up to this. Most commodities ETFs that hold futures contracts simply don't do a good job tracking the prices of commodities.

Monday, November 5, 2012

The most valuable commodity is information. I could hit the thesaurus and start coming up with different words for "information", but I won't do that - you get the point. Every investment one makes is, despite its underlying instruments, at its core, an investment in information. Whether you think a particular grain or metal will go up or down in value is the direct consequence of your information and the faith you have therein. In that way, buying a stock, or a gold contract, or a mutual fund, in essence, can be considered an investment in an information derivative. As a general rule, I'm not much of a fan of derivatives, whenever possible I prefer to invest in an instrument directly. Lucky for folks like me, there happens to exist a market that trades directly in information.

The Iowa Electronic Markets is commonly referred to as a stock market for predicting the future. More accurately, it's a futures market where the underlying commodities are discrete, real-world events. The market bills itself as follows:

The IEM is an online futures market where contract payoffs are based on real-world events such as political outcomes, companies' earnings per share (EPS), and stock price returns.

I, of course, realize that this is very similar to Intrade and other information market sites that offer contracts based on real-world events. The IEM, however is different in two important ways. First, it is entirely not for profit; there is no "house", making money on the trading activity, nor any recurring custodial fees, nor any party interested in impeding your withdrawals - the market is run by the University of Iowa as an educational resource of the business school. And second, most importantly, the IEM is entirely legal in the United States. The same cannot be said of other online information markets.
Regardless, here's basically how the IEM works using the current US Presidential Election as an example. The two outcomes for which contracts are issued by the market are:

Democratic Victory (in this case, President Obama)

Republican Victory (in this case, Governor Romney)

There are precisely the same number of contracts issued for each outcome, and the price for each contract trades between $.00 and $1.00, such that the total value of the two contracts combined is $1.00. The contracts trade on an open market with the familiar bid/ask market pricing structure. When the election is over, any contracts held for the winning candidate are redeemable for $1.00, regardless of what they cost, and any contracts held for the losing candidate are redeemable for $0.00000 (repeating, of course). As of writing, the Democratic contract (Obama victory) is trading at $0.750, and the Republican contract (Romney victory) is trading at $0.250. So, if you were to today purchase 100 Obama contracts for a total of $75.00, should the president win reelection, on Wednesday your contracts would be worth $1.00 each, or $100.00 total, good for a 33.3333 (repeating, of course) percent return on investment; alternately, if you were to buy 100 Romney contracts, your cost would be only $25, but should the governor win the election, you'd be looking at a 300% ROI.

(A quick aside, the contract is actually for the winner of the popular vote, rather than the winner of the electoral college and presidency, though the two are not always one and the same, you get the point.)

The market also allows participants to functionally short contracts by purchasing the same number of each contract (for $1.00 per bundle) and then selling any sub groups of contracts, in essence, betting that the price of the contracts held will go up in value compared to the price of the contracts sold. Since the two outcomes are mutually exclusive, they have a nearly one-to-one negative correlation.

All that said, the IEM is actually most notable not just for facilitating bets seen to maturity (when investors take delivery of their info-commodity), but for providing a market throughout the election season, thereby becoming something of a barometer for overall sentiment around the race at any given moment. In fact, historically, the IEM has been shown to be a better predictor of the outcomes of elections than most major polling sources. The ridiculous graphic on the right (which came directly from the IEM's website) provides an illustration of this fact from the 2008 presidential election. The price of a specific contract, in essence, represents the market's belief as to the probability of the associated event occurring. The theory goes that these markets end up being more accurate than polls because when people are forced to vote with their wallets, as much as they may like one candidate or the other, they're still Americans after all, and Americans rarely pass on an opportunity to make some cash.

So, back to the current year, when I say that the Obama contract is trading at $.75 to the Romney contract's $.25, this implies that, as of now, the market is giving Obama a 75% chance of winning the popular vote to Romney's 25%. Note how much more strongly the market is predicting an Obama victory than are most pollsters. However, this does not mean the market believes it's going to be a tremendously lopsided victory, in fact, just the opposite, as the IEM also offers a proportional vote contract that pays out based on the relative vote share for the major-party candidates (Republican or Democrat). That is, if you happen to be holding a Romney contract in this market, and Romney ends up winning, say, 48% of all votes cast either for Romney or Obama, that contract will be worth $.48, while an Obama contract would be worth $.52. As of writing, the Obama contract is currently sitting at $.505, while the Romney contract is trading at $.492 (an enterprising arbitrageur could take advantage of those totals not summing to $1.00).

So, the IEM is giving Obama a 75% chance of winning the popular vote, but only edging Romney out by something in the neighborhood of 1% of all votes cast for the two major candidates. Agree with those sentiments? If not, I know a place you could potentially make a profit from your contrarian sensibilities.

It's been said that knowledge is power, and for most investors power is money, but in the information markets, interestingly, money is also apparently knowledge.

If you're interested in investing in, or just learning more about the IEM and the presidential markets check out the following (I swear I'm not getting any kickbacks or anything, I'm just a fan):

NB: Obviously I've chosen to focus on the presidential election in this post, but the IEM offers contracts for all kinds of other events, often around politics, but also concerning miscellaneous goings on in the popular zeitgeist. All of which are, naturally, very, very interesting. It's a great market to follow.

Monday, July 9, 2012

Though not traded on a futures exchange, wine is still, literally anyway, a commodity. Further, it's a commodity that many people invest in, typically in the form of collectible rare/old wine. At a party when this ever comes up, usually someone says something like: "over time, rare wine is one of the safest investments when compared to blah blah blah". There's rarely any data to back this up, but that doesn't matter because it seems believable and it's kind of cool. Someone should look into that.

But rare wine isn't the order of the day. No, today I'm interested in exported wine. Specifically, wine exported to China. A recent article on GlobalPost.com (which is a publication I had never heard of until two weeks ago) addresses growing wine consumption in China:

Wine bars and boutiques are sprouting across Beijing, and trendy young consumers are flocking to wine-tastings at swish hotels. A dramatic 54 percent rise in wine consumption in China between 2011 and 2015 is predicted, a reflection of the increasing affluence of China’s middle classes, according to a new study by Vinexpo, Asia’s biggest wine exposition.

Let's leave aside for the moment that this study was conducted by a "wine exposition" (whatever that is) and focus on the purported reasoning behind the growth. Specifically, that the increase in wine consumption is "a reflection of the increasing affluence of China's middle classes." The article also goes on to say that 40% of Chinese wine imports are from France, specifically. Plenty of countries make wine; that the increase in imported varietals seems to be focused on Frenchwine implies not just that an increasingly affluent middle class wants to buy wine, rather, that they want to buy good wine.

Curious about how this trend might affect the American wine market, I pulled some numbers from the USDA Website via the FAS USTrade Query system. First, a look at total wine exports from the US, by country, over the last ten years (note, all volumes reported in Kiloliters):

US Total Wine Exports by Country, 2002 - 2011 (click to enlarge)

The first takeaway? Whatever amount of American wine the Chinese are importing now or in the next few years is largely insignificant at this point. We ship so much wine elsewhere that any changes in Chinese demand for US wine are unlikely to be of major concern for the next few years. That doesn't make it uninteresting, however. To get a better idea of the changes in China, specifically, let's take a look at the percentage of total US wine exported to four specific countries over that same time frame:

Percent total wine exports to four countries (click to enlarge)

Okay, now we're getting somewhere. As a percentage of total wines exported, one can see that the amount of wine we ship to China and Hong Kong has been gradually increasing, while that same total for Japan and France hasn't been following any overt pattern. Now let's compare the raw totals for the three biggest Asian importers of US wine:

Total imports from Japan, China, and Hong Kong (click to enlarge)

Interesting. The total amount of wine exported to Japan has more or less been hovering around 25,000 kiloliters, while exports to China and Hong Kong have steadily grown. But remember, the article tells us that the Chinese are developing a taste for French wine, which, accurate or not, has a reputation for being better than most other countries' wines. The next question, then, is what type of wine is China importing from the US? When reporting wine export numbers, the USDA breaks out the figures into six categories:

Sparkling Wine

Effervescent Wine

Grape wine of an alcoholic strength not over 14% in containers holding 2L or less.

Grape wine of an alcoholic strength not over 14% in containers holding more than 2L.

Grape wine of an alcoholic strength of over 14% in containers holding 2L or less.

Grape wine of an alcoholic strength of over 14% in containers holdingmore than 2L.

I don't know, exactly, what the distinction between sparkling wine and effervescent wine is, but types 3 through 6 could generally be thought of as "standard bottled table wine", "standard boxed table wine", "fortified wine" and "holy hell I have a death wish", respectively.

Standard table wine makes up the bulk of exports to all three of these countries, but here's where things get interesting. Let's look at how export numbers to Japan, China, and Hong Kong compare when caged specifically to standard table wine:

Standard table wine exports to Asia (click to enlarge)

Interestingly, the China and Hong Kong trends for standard bottled table wine follow pretty closely the general trends for ALL wines exported to those countries, while the Japanese trend looks altogether different. A little stats shows that this is precisely the case. Who knew the Japanese had such a taste for Night Train?

That means that ~97% of Hong Kong and China's change in wine importation from the US over the last ten years can be explained in terms of their importation of wine at 14% alcohol in containers smaller than 2L. That is, standard table wine.

The article mentions that the majority of wine consumed in China is produced domestically. What the change in export number then means, really, is not that China is drinking more wine, per se, but that more people are drinking better wine. To that end, the article's thesis is entirely correct, but not just for French wine, forall high quality wine. Until Chinese vineyards begin rivaling the quality and consistency of the best vineyards in France, the United States, and elsewhere, as China's citizenry gains spending power in the global economy, look for this trend to continue.

If you were hoping to come away with an investment idea here, you may be out of luck; there is no grape futures contract in existence, but even if there were, it's unlikely investing in such an instrument would be worthwhile. Grapes aren't the key here, it's craftsmanship, tradition, and quality. To that end, investors in rare wine may actually see a boon from the growth of wine exports to China. If demand for quality keeps up, that rising tide should, in theory anyway, boost the values of all high quality bottles.

Normally I'd say something like "it's a good time to own a vineyard in Napa or Bordeaux", but really there's no need to state a priori truths.

Tuesday, April 27, 2010

Hard Assets Investor just published an article of mine running down the new futures contracts that I had discussed previously (Cobalt, Molybdenum, and Distillers' Dried Grain), as well as the proposed Canadian Oil Futures contract. You can read the full article here.

Basic economics tells us that when demand stays constant and supply diminishes, prices go up. And according to this report, supplies, in fact, have diminished, albeit somewhat artificially. And how did the market react? It didn't:

Other than that spike the day of the announcement (April 5) natural gas investors apparently couldn't care less about the US Government's overstated inventory figures.

This highlights the fact that in the US we have access to about as much natural gas as we could ever want. Granted, a lot of it is underground, but unless gas stocks were actually low (like, in danger of running out) knowing that our stocks are slightly less than previously thought doesn't actually affect the price. At some point, the functional supply of gas changes from a number of mmBTUs to the categorical figure "plenty". If we got to a point where we were consuming enough natural gas to see stocks diminishing the gas drillers could ramp up production so quickly that no blip would be seen.

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